Currency: From the Gold Standard to Petrodollars to Crypto
Have you ever heard the phrase “good as gold?” The phrase harkens back to the time when U.S. dollars (“USD”) were backed by an equal or greater value of gold. This was known as the gold standard. Instead of paying for items by cutting and measuring flecks of gold, paper currency backed by gold was used. A USD was as good as gold. A great deal has changed since the gold standard was created, and the change is relevant to our thoughts about future investments. Because 2021 marks 50 years since the USD ceased to be backed by gold, we thought it would be worthwhile to recapitulate what has happened.
Currency allows for at least three important things: 1) the value of a trade can be stored and used later, 2) the value can be subdivided into multiple trades in multiple locations, and 3) currency is a means to impart incentives through time. As we have heard Berkshire Hathaway’s Charlie Munger say on several occasions “show me the incentive and I will show you the outcome.” In our opinion, the use of currency facilitated the formation of civilizations, economic growth, and innovation. Inversely, civilizations, economic growth and innovation probably would not do well without a stable currency.
Some of the earliest forms of banking can be found in biblical descriptions of the temples and the money changers. Citizens brought valuables to the temples for safe keeping (perhaps where the word “treasury” comes from), and loans were often made from the temples as well. Quite a bit is written about money and charging interest in the Bible. The point is that money was most often backed by hard assets.
Instead of using paper money or other easily produced material, coins were made of precious metals and paper currency was backed by hard assets to create stability by constraining the supply of money. However, leaders and governments are incentivized to inflate currencies for various purposes, especially under economic crisis and wartime. For example, we show a chart of the debasement of Roman imperial coins over time. (2)
Source: https://en.wikipedia.org/wiki/Denarius
Economies around the globe have been especially interested in transacting in a currency with a high likelihood of persisting long into the future. In the 1930s, to enable the Federal Reserve to increase the money supply to combat dire deflationary conditions, FDR took extreme actions under executive order and made personal gold ownership above certain levels illegal and forced citizens to turn in their gold. Several ally countries shipped their gold to the U.S. for safe keeping during WWI. In 1944, the Bretton Woods Agreement was created whereby the U.S. held gold and issued currency and debts for the world to use for trade. This allowed the USD to become the global reserve currency. It could be argued that the World Wars created the ability for a USD global monetary system.
The Bretton Woods Agreement worked well for the first couple decades because the U.S. held so much gold that it was able to continually print more and more USD for the world to use. But as the U.S. steadily increased the USD in circulation, some countries became concerned and gradually shipped their gold back from the U.S. This accelerated during the Vietnam War because the U.S. further ramped the printing of USD to fund the war. As countries returned dollars for gold, there was no longer enough gold to back all the USD in circulation. Bretton Woods ended in 1971.
For what it is worth, Britain was on the gold standard when London was the financial center of the world in the 1800s and early 1900s. When Britain came off the gold standard to finance WWI, it ceased to have the world’s reserve currency. In that way, the ending of Bretton Woods was not surprising.
All “fiat” currencies have value because the government says so and because market participants go along with it. A global system comprised of only fiat currencies does not seem stable because countries can print a seemingly endless amounts of fiat currency at any time. So, global participants should naturally be searching for a solid reserve currency, and in 1974, they found it in the form of “petrodollars.” Instead of being backed by gold, Saudi Arabia sold oil all around the world in USD denominated transactions. Saudi Arabia trusted the U.S. would be better at managing relative price stability while making USD available around the world, versus transacting in numerous fluctuating currencies. Countries needed USD to buy oil, and the U.S. was happy to oblige. Even though USD was not truly backed by a hard asset, and was therefore technically still a fiat currency, the petrodollar system reinforced a consistent long-term demand for dollars.
The demand for USD almost required the US to run trade deficits. In important ways, petrodollars were a fantastic facilitator of the massive wave of offshoring manufacturing to countries with low labor and production costs. Growing countries that often transacted in USD would end up with excess USD and would buy U.S. debt with the excess USD. The biggest example is China, which became the single largest holder of U.S. debt over several decades, as China experienced tremendous growth.
Many countries have issued USD denominated debt and/or have USD denominated assets. For emerging market countries with USD denominated debt, USD strength is like fiscal tightening and USD weakness is like fiscal easing. For emerging market countries with USD denominated assets, USD strength is a boon while USD weakness decreases the value of USD denominated assets. Even though volatility in the USD may disproportionately impact smaller countries, the world presently needs the USD to function.
The Belt and Road initiative by China is a clever strategic play. In recent years, instead of buying U.S. debt with the excess USD it accumulates through the year, China makes USD based loans in countries rich with minerals and important assets. Presumably China gets ownership of strategic assets in case of a default on a loan. The chances of default increase with a recession or if the USD simply appreciates significantly, and doubly so if both occur simultaneously.
We are living in the digital age in the U.S. where cash is used in only 26% of transactions (3). The USD has stealthily transformed to a predominately digital currency, and so it seems less important that the currency be backed by gold.
The USD is so woven into the financial fabric of the world that it could not be quickly unraveled. Given the brief history of the USD described above, it is easy to see how volatile or even revolutionary the global environment might become with a relatively sudden change in USD reserve currency status. As the global economy grows, there should be room for the expansion of non-USD payments and payment systems. Escalated discussions about crypto currencies make perfect sense in the context of the pandemic and last century, though we do not yet see a viable path for crypto currencies to be broadly adopted. We do not see anything on the horizon that is likely to alter the USD’s reserve currency status or functioning of the global financial systems, though we are concerned that central bank policy is facilitating excessive government spending that could threaten reserve currency status longer term. We share this historical perspective because of its relevance and simply to let you know we are thinking about it.
Ultimately, we believe owning shares of companies generating revenues in multiple currencies, with pricing power, and low incremental capital and labor expenditure requirements, will help protect your investments from inflationary economic conditions.
References:
We would like to acknowledge that we read many articles, reports, and papers on these topics which helped shape our perspectives. Deutsche Bank, JP Morgan, and Lyn Alden each wrote several relevant pieces.
(3) https://www.frbsf.org/cash/publications/fed-notes/2019/june/2019-findings-from-the-diary-of-consumer-payment-choice/
Redmond Asset Management, LLC October 2021
The opinions contained in the preceding commentary reflect those of Redmond Asset Management, LLC. The stated opinions are for general information only and are not meant to be predictions or an offer of individual or personalized investment advice. They also are not intended as an offer or solicitation with respect to the purchase or sale of any security. This information and these opinions are subject to change without notice. Any type of investing involves risk and there are no guarantees. Redmond Asset Management, LLC does not assume liability for any loss which may result from the reliance by any person upon any such information or opinions.
Redmond Asset Management, LLC (RAM) is an independent, SEC registered investment management firm located in Richmond, VA and is not affiliated with any parent organization. RAM was founded in 2005 and registered with the SEC on 22 Dec 2005. The company offers investment management services for equity, balanced and fixed income portfolios to corporate, institutional, and individual investors.
